We'll consider the evidence from four different passively managed small-cap portfolios:
- The DFA Tax-Managed Small Cap Portfolio (DFTSX)
- The DFA Small Cap Portfolio (DFSTX)
- The Russell 2000 Index
- The S&P 600 Index
For example, the annual dispersion averaged more than 13 percent for the period 1999-2003 and was as great as 17.7 percent. Then from 2004-07, the dispersion averaged 3.5 percent (still a figure that's likely much higher than the average investor would guess), and never exceeded 5 percent. In 2008 and 2009, with the increased volatility in the market, the yearly dispersion again increased to 7.3 and 10.8 percent respectively.
For the full 11-year period 1999-2009, the yearly dispersion averaged almost 9 percent. However, the cumulative dispersion in returns declined virtually every year. Over the full 11-year period, the dispersion was less than 2.4 percent, demonstrating that much of the differences in annual dispersion are random.
You're best served by looking at the long-term data, and the longer the better. The dispersion of returns in the short-term can be very misleading. For example, despite similar risk characteristics, the DFA Small Cap Portfolio outperformed the S&P 600 Index by about 13 percent in 1999. The following year, the relative performances reversed with the S&P 600 Index outperforming by 9.4 percent. For the full period 1999-2009, the returns dispersion had shrunk to less than 0.5 percent, with the live DFA Small Cap Portfolio outperforming the S&P 600 Index (which has neither expenses or trading costs) 7.4 percent versus 6.9 percent. Over the same period the Russell 2000 returned 5.0 percent.
The following is another example of why you shouldn't pay too much attention to short-term data. The DFA Tax-Managed Small Cap Portfolio is very similar to the DFA Small Cap Portfolio in terms of risk characteristics. The difference is in how the funds are managed for tax efficiency. The Small Cap Portfolio is meant to be held in tax-advantaged or non-taxable accounts and thus seeks to achieve the highest pre-tax return. The tax-managed fund's goal is the highest after-tax return (even if that means lower pre-tax results).
For the full period 1999-2009, the tax-managed fund lost only about 0.2 percent per year to taxes. The Small Cap Portfolio lost about 1.2 percent per year. On a pre-tax basis, through 2008, the tax-managed fund underperformed by 0.35 percent (4.49 percent versus 4.84 percent). Since it had lost about 1 percent less to taxes, it achieved its goal of producing higher after-tax returns. But, you'd have to check for those figures to know that! Let's now look at what happened the following year.
2009 was a very volatile year for the markets. And, as we might expect, the increased volatility led to an increased dispersion of returns. In 2009, the tax-managed fund underperformed its counterpart by just over 10 percent. Thus, for the full 1999-2009 period, the difference in pre-tax returns had widened to 1.07 percent (7.37 percent versus 6.3 percent), meaning the non-tax-managed fund now had a slight advantage (6.17 percent versus 6.1 percent.